Budget Cuts Hurt Rheinmetall to Cobham as U.S. Protects Programs

European defense companies from Rheinmetall AG (RHM) to Cobham Plc (COB) are bearing the brunt of government budget cuts, contrasting with a more upbeat outlook in the U.S., where companies are still showing resilience to reductions.

Rheinmetall, which makes the Leopard 2 battle tank, became the latest victim of a market in decline, reporting an 8 percent drop in first-half revenue today after already axing its full-year forecast lats month. The company joined Cobham Plc, Finmeccanica SpA (FNC) and Sweden’s Saab AB (SAABB) in providing a muted outlook or lower earnings as governments curtail spending.

The decline in Europe stands in contrast to the U.S., where missile maker Raytheon Co. (RTN) joined Lockheed Martin Corp (LMT), the world’s largest arms maker, and Northrop Grumman Corp. (NOC) in reporting second-quarter profits that beat analysts’ estimates and raised profit outlooks for the full year. Those companies have each gained more than 30 percent this year, making them three of the four best performers on the Standard and Poor’s 500 Aerospace & Defense Index.

“It is the U.S. top primes coming out of this smelling like roses because the big programs are being protected,” Nick Cunningham, a London-based analyst at Agency Partners, said in a telephone interview. “The European governments don’t spend enough to maintain a healthy defense manufacturing industry and so companies are very reliant on very lumpy exports.”

In Decline

European Aeronautic, Defence & Space Co., the parent of Airbus SAS, is merging its defense and space activities to give the combined business more heft, and the company has predicted little growth at home for coming years as governments tighten budgets.

The French government on Aug. 2 announced a five-year military spending plan that trims purchases of Rafale fighters, made by Dassault Aviation SA (AM), to 26 planes from more than 60. Spain also said it plans to cut military plane purchases.

“The defense business is going down, it is shrinking in Europe,” EADS Chief Executive Officer Tom Enders said July 31. “Our forecast is that at least for the rest of the decade it will stay a flat or shrinking business.”

The situation in the U.K. is more mixed, with cuts already having taken place after the 2010 Strategic Defense & Security Review and now stabilizing, Cunningham said.

BAE Systems Plc (BA/), Europe’s No. 1 defense contractor, slightly improved its full-year earnings outlook on Aug. 1 to double-digit growth in underlying earnings per share, with an improved outlook for its U.K. business, even as the sales outlook for its U.S.-based land-vehicle activities weakened.

Reduced Spending

Automatic spending reductions, or sequestration, created by President Barack Obama and congressional Republicans as a penalty for failing to agree on a deficit-reduction strategy, will strip $1.2 trillion from national security and domestic programs over nine years unless an alternative is enacted.

U.S. Defense Department spending on contracts fell 9 percent to $361 billion in the year ended Sept. 30 from the 2008 peak of $397 billion, according to data compiled by Bloomberg.

Even as big-ticket equipment purchases have been shielded from U.S. cuts, companies have been hurt primarily on reductions in shorter-term contracts that come up for renewal.

“It is short-cycle areas such as services and some electronics where you are seeing the impact of these cuts,” said Robert Stallard, a London-based analyst at RBC Capital.

Cobham is among those hurt the most, he said. The Wimborne, England-based company reported a 7 percent decline in organic revenue at its U.S. defense and security operations, the largest sales contributor.

Short-Cycle Demand

“Our concern is always on the short-cycle business,” CEO Bob Murphy told analysts yesterday as he adjusted the earnings outlook to reflect sustained uncertainty in U.S. spending plans, including the absence of a budget for the fiscal year starting in October.

Other European companies, many of which are exposed to the U.S. on shorter-term training and services contracts that have been hit hardest, also blamed U.S. spending. Saab’s CEO, Hakan Buskhe, predicted last month that “budget uncertainty may ‘‘go on for some more years.’’

U.S. Defense Secretary Chuck Hagel said July 31 the Pentagon will have to choose between a decade-long ‘‘modernization holiday’’ cutting equipment spending or a smaller military. If budget cuts are not reversed, programs including the Lockheed Martin F-35 Joint Strike Fighter, the Pentagon’s single biggest weapons program, could suffer under options Hagel said came out of a ‘‘Strategic Choices and Management Review.’’

‘‘We think there’s more to come on sequestration,’’ Boeing Chief Executive Officer Jim McNerney said July 24. ‘‘We are not out of the woods at all. We’re just entering the woods.’’

To contact the reporter on this story: Robert Wall in London at rwall6@bloomberg.net

To contact the editor responsible for this story: Benedikt Kammel at bkammel@bloomberg.net

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